Dollar Firm as Two-Day FOMC Meeting Begins

July 25, 2023

Win Thin

The two-day FOMC meeting begins today and ends tomorrow with an expected 25 bp hike; regional Fed surveys will continue rolling out; yesterday’s data are worth discussing; Conference Board reports July consumer confidence; Brazil reports mid-July IPCA inflation
ECB Bank Lending Survey showed demand plunged in Q2; ECB tightening expectations have fallen ahead of the Thursday decision; Germany reported soft July IFO business climate readings; U.K. CBI released the results of its July industrial trends survey; Israel’s Knesset passed the first part of the controversial judicial reforms; Hungary is expected to keep the base rate steady at 13.0%
Japan Cabinet Office released its longer-term macro forecasts; Korea reported Q2 GDP data; Indonesia kept rates steady at 5.75%, as expected; CNY is outperforming on rising optimism regarding stimulus in China

The dollar continues to climb as the two-day FOMC gets under way. DXY is trading higher for the sixth straight day near 101.471. The next key retracement levels from the July swoon come in near 101.575 (50%) and 102.045 (62%). The euro is trading lower near $1.1045 while sterling is trading slightly higher near $1.2845. USD/JPY is trading flat near 141.40 after trading Friday at the highest since July 10 near 142. A break above 142.10 is needed to set up a test of the June 30 high near 145.05 and we believe a hold from the BOJ this Friday will trigger a move higher in this pair. We had been frustrated with recent dollar weakness but the relative fundamental story seems to be shifting back in favor of the greenback. The FOMC, ECB, and BOJ decisions this week are widely expected to underscore the divergence them and so further dollar gains seem likely.

AMERICAS

The two-day FOMC meeting begins today and ends tomorrow with an expected 25 bp hike. Forward guidance will be key. We strongly believe the Fed should not signal another skip in September, as doing so for the June meeting really handcuffed the Fed at a time when it needed maximum flexibility. Given how firm the labor market remains, we believe the right thing for the Fed to do is to emphasize a more data-dependent approach and stress that a skip in September should not be assumed. There won’t be updated macro forecasts and Dot Plots until the September meeting. WIRP suggests odds of a hike then around 15% and top out near 40% November 1. It’s worth noting that the first cut is now priced in for next May vs. March at the start of this week. However, this remains wide open to repricing and is fully dependent on the data.

S&P Global preliminary PMIs came in softer than expected. Manufacturing came in at 49.0 vs 46.2 expected and 46.3 in June, services cane in at 52.4 vs. 54.0 vs. 54.0 expected and 54.4 in June, and composite came in at 52.0 vs. 53.0 expected and 53.2 in June. ISM PMIS out next week hold more weight but even with the S&P Global readings, the U.S. continues to outshine the eurozone (48.9 composite), the U.K. (50.7), and Australia (48.3). This should be underscored by Q2 GDP data later this week. Of the major economies, only Japan is holding up as well as the U.S. with its composite PMI of 52.1. China reports its official July PMIs next week and the composite is likely to fall significantly from 52.3 in June.

Regional Fed surveys will continue rolling out. The Philly Fed non-manufacturing index today, along with the Richmond Fed’s manufacturing (-10 expected) and business conditions surveys. Kansas City Fed manufacturing index (-10 expected) will be reported Thursday, followed by its services index Friday.

Chicago Fed National Activity Index for June is worth discussing. The headline came in at -0.32 vs. -0.13 expected and a revised -0.28 (was -0.15) in May. Yet the 3-month moving average still fell to -0.16 vs. -0.21 in May. This was slightly weaker than expected but overall shows resilience in the economy. Yes, it may be growing slightly below trend (we'll know more after Q2 GDP data Thursday) but the U.S. economy is still far from recession. Recall that the recession signal is when the 3-month moving average hits -0.7. This series has taken on greater significance given that the 3-month to 10-year curve remains deeply inverted. The continued resilience in the economy is noteworthy and suggests the Fed still has more work to do in getting to the desired sub-trend growth.

Conference Board reports July consumer confidence. Headline is expected at 112.0 vs. 109.7 in June. If so, it would be the highest since December 2021. University of Michigan reports its final July reading Friday. The preliminary reading of 72.6 was the highest since September 2021 and this improvement would line up with the Conference Board.

Brazil reports mid-July IPCA inflation. Headline is expected at 3.26% y/y vs. 3.40% in mid-July. If so, it would be the lowest since mid-September 2020 and firmly near the center of the 1.75-4.75% target range. With inflation under control, markets are looking for the start of an easing cycle with a 50 bp cut to 13.25% at the August 2 COPOM meeting. Looking ahead, the swaps market is pricing in 100 bp of easing over the next three months followed by another 125 bp of easing over the subsequent three months. Please see our recent piece on EM monetary policy here.

EUROPE/MIDDLE EAST/AFRICA

The ECB’s latest Bank Lending Survey showed demand for loans by companies plunged by the most on record in Q2. The drop was “substantially stronger” than banks expected and comes when demand for mortgages and other consumer borrowing is also weakening, according to the ECB. The quarterly survey began back in 2003. It also showed that credit tightening was due in part to supply factors, as banks tightened up their lending standards. The data clearly show that the DCB’s unprecedented tightening campaign is having a large impact on the economy. The question is whether the central bank is prepared to trigger a deep downturn in order to get inflation back to its 2% target. Of note, June M3 data will be reported tomorrow and is expected at 0.8% y/y vs. 1.4% in May. If so, it would be the slowest since April 2014 and signals slower economic activity ahead.

ECB tightening expectations have fallen ahead of the Thursday decision. A 25 bp hike is widely expected but the rate path going forward is open to debate. WIRP suggest odds of another 25 bp hike stand near 50% September 14, rise to 70% October 26, and top out near 75% December 14. The messaging this week will be key. Given recent weakness in the data, we expect the ECB to set forth a conditionally hawkish message that is much more data-dependent than the one it gave in June. Updated macro forecasts will come at the September meeting.

Germany reported soft July IFO business climate readings. Headline came in at 87.3 vs. 88.0 expected and 88.5 in June, with both current assessment and expectations falling to 91.3 and 83.5, respectively. This was the third straight drop from the 93.5 peak in April and a further drop is likely. August GfK consumer confidence will be reported Thursday and is expected at -24.8 vs. -25.4 in July. Germany has been the weak link in the eurozone but France and Italy are quickly catching up, with Spain also likely to tip into recession.

The U.K. CBI released the results of its July industrial trends survey. Total orders came in at -9 vs. -18 expected and -15 in June, selling prices came in at 18 vs. 16 expected and 19 in June, and business optimism came in at 6 vs. 3 expected and -2 in June. Quite frankly, we are surprised that the readings were so firm given the marked deterioration in the PMI readings. This month’s newfound optimism amongst U.K. firms is likely to reverse in the coming months. Results of its distributive trades survey will be reported Thursday, with retailing reported sales expected to remain steady at -9.

BOE tightening expectations remain subdued. WIRP suggests odds of a 50 bp hike August 3 have fallen below 45% after being largely priced in at the start of last week. Looking ahead, 25 bp hikes are priced in September 21 and November 2 and the odds of one last 25 bp hike top out near 60% in February. This new expected rate path would see the bank rate peak between 5.75-6.0% vs. 6.0% at the start of this week, 6.25% at the start of last week, and 6.5% at the start of the week before that. This is a huge downward adjustment that may not be over yet but is nevertheless taking a huge toll on sterling.

Israel’s Knesset passed the first part of the controversial judicial reforms. The vote was 64-0 as the opposition boycotted the vote. The government’s strategy is to pass the entire package piecemeal and so tensions are only likely to get worse as each part is passed. Protests had intensified leading up to this initial vote and are now likely to get even worse. Reservists in the IDF have threatened to not report for duty and this raises serious national security concerns. Commerce is likely come to a screeching halt. The list goes on but the shekel and the economy are likely to continue weakening while the central bank will be under pressure to hike rates to support the currency. USD/ILS has risen sharply this week and is on track to test the June high near 3.7545. Break above that would set up a test of the March 2020 high near 3.89.

National Bank of Hungary is expected to keep the base rate steady at 13.0%. However, it is likely to cut its 1-day deposit rate 100 bp to 15.0% following similar cuts in May and June. The bank’s implied aim is to cut this rate by 100 bp per month until it converges with the 13% base rate. Furthermore, the swaps market is pricing in 125 bp of easing in the base rate over the next three months followed by another 250 bp over the subsequent three months. Note that the forint is the fourth best performing EM currency YTD but the early easing cycle has led to increasing underperformance so far in H2.

ASIA

Japan Cabinet Office released its longer-term macro forecasts. It sees headline inflation around 0.7% from FY27 to FY32 in its baseline scenario. This comes after forecasts of around 2.6% in FY23, 1.9% in FY24, and 1.2% in FY25. These forecasts come ahead of the BOJ meeting, when it also releases updated forecasts. We suspect the BOJ’s will fall largely in line with the Cabinet Office’s and suggest little urgency to tighten policy. The report also set forth a more optimistic growth scenario whereby inflation instead hits 2% by FY26 and stay there over the rest of the 10-year horizon. Separately, the Cabinet Office sees the primary balance near -4.7% of GDP for FY23 but still aims for a primary surplus by FY25 after a projected -0.8% in FY24. This seems wildly optimistic. Lastly, it forecasts 1.3% GDP growth in FY23 and 1.2% in FY24.

Korea reported Q2 GDP data. Growth came in a tick higher than expected at 0.6% q/q vs. 0.3% in Q1, while the y/y rate remained steady at 0.8%. The Korean data are consistent with Singapore’s (0.3% q/q and 0.7% y/y) in terms of showing continued sluggish growth. Of note, China’s Q2 GDP readings (0.8% q/q and 6.3% y/y) were distorted by the impact of Covid Zero shutdowns last year. June retail sales will be reported tomorrow and IP will be reported Friday.

Bank Indonesia kept rates steady at 5.75%, as expected. However, it cut reserve requirements for certain banks that would free up an estimated IDR47 trln in liquidity. Similar to the last meeting June 22, Governor Warjiyo stressed that “The policy focus is oriented towards strengthening rupiah stability to manage imported inflation and mitigate the contagion effect of global financial market uncertainty.” Bloomberg consensus sees the start of an easing cycle with 25 bp in Q4 followed by another 25 bp in Q2, suggesting a very cautious stance. We concur. With the Fed expected to maintain tight policy, we believe that Bank Indonesia has very little cushion to cut rates without weighing on the rupiah.

The yuan is outperforming on rising optimism regarding stimulus in China. Aa things stand, there have been no concrete details, only vague promises. Quite frankly, it’s hard to get excited about a stimulus plan that centers on pumping up the overbuilt and over-indebted property sector. What’s left unsaid is how much more debt will be incurred from these plans. In addition, monetary policy will have to be loosened further and that will only move interest rate differentials further in the dollar’s favor. Bottom line: we’d fade this bounce in the yuan.

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